‘Gerbil banking’ preceded the Great Depression. We’re seeing it again today

Banking in the 19th century was notoriously unstable, with bank runs or “panics” coming all too frequently. By the turn of the 20th century, such runs were almost seasonal, prompting depositors to withdraw in advance of what might be a coming run, thereby, of course, precipitating liquidity crises at banks. This came to a head in the Panic of 1907, the granddaddy of panics, when the banking system collapsed.

Congress at that time considered an array of solutions to bank instability such as deposit insurance (favored by the Democrats), postal savings (favored by the Republicans), and a central bank (favored by almost none of them but viewed as something to study). Republican William Howard Tafts’ election in 1908 sealed the deal, and we got a Postal Savings system.

The idea of Postal Savings was simple. There were post offices everywhere and they would take deposits from individuals, paying them a slightly lower interest rate than the banks offered (a maximum deposit of $2,000 was also imposed to reduce competition with the banks). Now, when individuals became concerned about bank solvency and withdrew their funds, they could put the money in Postal Savings instead of under their mattresses. And what would the Postal Savings system do with the funds? Put the money back into the banks!

This gerbil-like treadmill would thus keep the funds in the banking system, while giving the Postal Savings system interest on its bank deposits to pay the system’s depositors. The circularity of flows out of and then back into the banking system at the heart of the Postal Savings system did have a certain cleverness to it.

As David Easley and I showed in a research paper, this system worked pretty well until the onset of the Great Depression. Faced with growing numbers of bank failures, even the Postal Savings system lost faith in the banks, and so shifted its investments from deposits to government bonds. While certainly not the major cause of banking’s problems, we showed that this action contributed to the liquidity problems undermining the banking system. With the collapse of the banking system in 1933, the view that the Postal Savings system could restore stability to the banking system similarly vanished, setting the stage for the establishment of FDIC deposit…